Dollar the winner in a commodities anti-super cycle

One of the most notable market developments during the past year has been divergence between stock prices, which have rallied strongly due to the expansionary monetary policy stance of the world’s largest central banks, and commodity prices, which have headed lower amid talk of the end the commodity super cycle as global inflationary pressures have failed to materialize.

As the chart below shows, the last time the S&P index and the CRB commodity price index failed to move in lockstep was in the late 1990s, during the heyday of the tech boom.  

That development matters for the dollar since, as Alan Ruskin, strategist at Deutsche Bank, points out, during the past 20 years the currency has tended to trade strongly in an environment where equities are outperforming commodities, and has tended to trade poorly when the S&P/CRB ratio heads lower.

Partially, that reflects the fact a stronger dollar suppresses commodities priced in the currency, although offsetting that a stronger dollar can often also weigh on US stock prices.  

The question now is whether the relationship between the S&P/CRB ratio and the dollar is likely to hold up during this cycle, and produce the kind of rally seen in the currency in the late 1990s.

Some point to the persistent funding gap in the US economy as an impediment to such a development, but Ruskin believes there is reason to believe the dollar will turn higher.

He notes that weaker commodity prices are partly related to the positive US energy shock caused by a boom in American oil production, which in turn has provided a boost to the US terms of trade that should support the dollar.

In addition, the rise of the S&P has been associated with a rise in capital inflows into the US that has boosted the dollar.

“Until now, a pick-up in these flows has been largely absent, which has contributed to the slow nature of the turn higher in the dollar,” says Ruskin.

More importantly for the dollar, however, is the effect on Federal Reserve monetary policy relative to its peers.

In 1999, the S&P rose, oil prices doubled and inflation went up, but the Fed only tightened policy late in the day relative to other central banks to provide the dollar with support.

In contrast, in the current cycle, oil prices are steady and lower global inflation rates are tracking lower global commodity prices rather than following higher equity prices. Inflation, in other words, is unusually benign this far into a global recovery.

However, unlike other large central banks, the Fed, as demonstrated by chairman Ben Bernanke’s testimony on Wednesday, is starting to consider scaling back its accommodative monetary policy stance.

“The Fed is an outlier among major central banks in edging ever so slowly toward less accommodation,” says Ruskin. “The more the Fed is prepared to ignore the drift lower in core inflation, the more this is dollar positive.”

Ruskin believes the positive US energy shock has helped the numerator and denominator in lifting the S&P/CRB ratio.

“This only adds to the prospect that the rise in the S&P/CRB ratio is associated with a stronger dollar in this cycle, through multiple linkages that include terms of trade and [monetary] policy,” he says.

In the short-term, the dollar’s prospects will be dependent on US economic data. The Fed has, after all, stated that is what will influence any decision on tapering in asset purchase plans.

However, for the longer-term direction of the currency, the diverging fortunes of equity and commodity prices would appear to be worth monitoring.